What I Meant in Accounting Education under IFRS

Am I going overboard? I hope not, hate getting wet. Let’s see what Dennis Beresford, former chairman of the FASB and current accounting professor, has to say about my previous post. Denny is quoted from AECM, the international listserv for accounting professors. On Thursday, November 27, 2008, he says:

Dennis Beresford, former Chairman of FASB, now accounting professor at University of Georgia

Last year I had Julie Erhardt speak to my graduate accounting classes and meet with some of our accounting faculty. Julie is the SEC Deputy Chief Accountant in charge of all of the international accounting effort. One of the faculty members asked about how we could teach IFRS on top of U.S. GAAP. Julie gave what I thought was a very interesting and insightful response.

Julie said that perhaps we could change our approach to financial accounting to one in which most of the focus in the first place was on business issues. For example, if covering lease accounting, the instruction could begin with the differences between buying and leasing an asset, what are the economics of doing one vs. the other, and what would be the effects on financial statements of capitalizing leases vs. expensing lease payments as they are incurred. Then the coverage could move on to the fundamental principles that determine whether leases should be capitalized or not e.g., how much of the fair value is covered by lease payments. Only after the economic issues and the basic principles are covered would some of the details (e.g., what to do with contingent rentals) that distinguish IFRS from GAAP be mentioned. In this approach, about 50% of the effort would be on the economics, 25% would be on the principles (that ought be to pretty similar), and 25% on the rules (that could be different).

This kind of approach would almost certainly deal better with “why” we account for things in particular ways vs. what seems to be today’s approach of emphasizing “what” to do without enough attention to the underlying reasoning. I think this is similar to what Dave suggests below. And it’s similar to what I tried to do when I taught the basic financial accounting class for MBA students.

Thanks for sending this Denny. I had some of this in mind when writing my previous post. To be sure, it does represent a change from what I currently do. For undergraduate students, I spend much of the class time explicitly going over how the accounting for leases impacts the four financial statements. One of the key points to my presentation is that the underlying economics of a lease is essentially the acquiring of an asset and an agreement to pay for that asset over time. Despite the economics, lessee companies have two options for reporting. Under the first option, lessee companies can choose an income statement approach, where all payments are reflected in operating income as rent expense, cash flows are classified as operating activities, and there is nothing reported in the balance sheet. Under the second option, the asset does appear on the balance sheet (along with the tag along liability separated into current and non-current), expense is parsed into operating income for the asset depreciation and non-current for interest expense, and cash flow is parsed into operating activities (for the interest) and financing activities (for lease payable reduction).

I make sure to emphasize that the two widely different accounting treatments could be applied to any lease, it is all a matter for how the lease is classified. To drive this key point home, I have students do the accounting two ways for each fact situation, as if it had been classified as operating and if it had been classified as capital.

But I also think it is important for us to start teaching income smoothing. Why do I say something so radical and sleazy?

Income Smoothing as applied to a bumpy stream of actual net income.

We all know that corporate execs have been manipulating earnings for years. One stated reason for ditching GAAP is that the execs would not follow the rules because rules generated unacceptable numbers. Under the switchover to IFRS, the execs have been given what they want, new accounting tools with enough flexibility to permit the disclosure of practically any number.

All the key players tied to the IFRS switchover have made comments revealing these points: (1) companies in one industry may account differently for a transaction than companies in another industry, (2) companies in the same industry may not account for a transaction in a similar manner, and (3) a company need not account for identical transactions the same way. The professional judgment of corporate execs referred to so frequently in IFRS is a euphemism for income smoothing.

If corporate execs have been given license to smooth income, then I think accounting and business students should learn how to do so in college.

While there are some things that matter to traditionalists, such as the transaction itself and its economics, I don’t think these matter more than the story that execs want to tell. For example, under lessee accounting under IFRS, a lessee may account for a lease as a capital lease, an operating lease, and partially operating partially capital. The decision is to be made on a contract by contract basis, similar to the accounting for fair value assets where banks may account for some under fair value and some under held-to-maturity. Company choice is guided only by the income statement impact, an IFRS concession forced by the European Union. Why should lease accounting be any different?

Since the purpose of IFRS is to make it easier to raise capital, the reaction of investors/lenders to any reported number is germane to the exec decision about whether or not to report it. And we all know that investor reactions depend upon their perceptions of the future. Therefore, I think an essential characteristic for choosing an accounting treatment in the present year is the ability of the company to sustain this treatment approach in future years for future transactions. Consistency and trend are the keys.

I’m sincere about teaching earnings managment strategies. Perhaps we can have a positive impact on the practice of accounting, an impact every bit as great as that which results from teaching ethics to business students. And, my suggestion here is not of sour grapes. The rules have changed, and I think we should fully embrace the rules.

I won’t actually teach income smoothing until it becomes an integral part of the curriculum. I’m a chicken and I want a job. Never-the-less, I believe that we should start teaching income smoothing.

2 Responses

The income smoothing takes place in when the initial decision is made on how to account for the lease. Since most reporting companies typically initiate many leases each year, the smoothing takes place at the portfolio level.

This is different from what is taking place with fair value accounting and IFRS. In Europe, companies can elect to account for various types of securities on fair value or historical cost (held-to-maturity). In Europe under IFRS, companies can freely switch the accounting from fair value to historical cost and back again, on a security by security basis.

And, going back to leases, it is possible to switch mid-stream from operating to capital, or vice versa. However, I think this switch should only be done once. It would never come to this, as there are typically so many new leases started each year that accounting changes would not need to be done.

Sorry, but I don’t see how IFRS lease accounting can amount to income smoothing. You have to decide on a per-asset basis if it’s an operating or finance lease, but once you’ve made your decision, you can’t change it every year. Income smoothing means window-dressing the profits every quarter or year, not being free to decide the classification of transactions which will affect the long-term.